Islamic profit-rate swap in Q1

Profit-rate swap to address Shariah-compliant hedging risk

By

Reuters

PublishedSunday, November 27, 2011

International Islamic Financial Market (IIFM) expects to launch a template for sharia-compliant profit-rate swaps, designed to help in hedging risk in frequent cross-currency transactions, in the first quarter of next year, its chief executive said.

Ijlal Alvi said IIFM, a global body which works to standardise Islamic finance products, was close to finalising the template, which will standardise documentation in the use of profit-rate swaps among Islamic institutions.

"That standard documentation for the profit-rate swap product will be available soon. We would generally keep the first quarter for now," Alvi said in an interview with Reuters in Bahrain. "We have tested with some core banks already and got their views on it. Now it's really just more about getting the sharia (approval by Islamic scholars)."

Alvi said, "There is a need to control risk, such as currency volatility for a sukuk issued in another currency or a venture capital deal in which the balance sheet is another currency. We're seeing such a pipeline, for instance, of sukuk in recent days so the need for profit-rate swaps is also coming in."

Profit-rate swaps are intended to achieve the economic effect of interest-rate swaps, through the use of underlying sharia-compliant undertakings and mark-up sale transactions.

Advocates say Islamic financial institutions have long needed the hedging product to deal with mismatches between the fixed-rate profile on some of their assets and variable-rate profile on their liabilities, and vice versa.

Sukuk issuance has outpaced the conventional bonds industry in recent months and is expected to remain strong into the first quarter of 2012, as borrowers seek better pricing and alternative funding amid the global debt crisis.

PROBLEMATIC

Sharia-compliant derivative products have in the past been problematic within the Islamic finance industry. In conventional finance, hedging can be used not only to manage risk but also to gamble or speculate, which is forbidden in Islam.

Last year IIFM launched a broader Islamic derivatives contract template, known as the Tahawwut Master Agreement, to provide Islamic institutions with a simpler format for risk management that has been approved by sharia scholars. But the document has been slow to catch on in some parts of the industry, where it is viewed by some as unwieldy.

Still, Alvi said the need for hedging products would become increasingly apparent as the nearly $1 trillion Islamic finance industry continued to grow rapidly, and as standardised documentation approved by sharia scholars became available.

He also said his organisation would look to create a standardised wakala agreement in 2012. Wakala is an agency agreement in which one firm accepts funds from another to invest on its behalf in a sharia-compliant manner.

IIFM is putting together a first draft of the document following a consultative meeting with banks, scholars and law firms, and will provide it for wider feedback.

"We are hoping once the wider phase is done, we'll cover most issues that come up and are aiming to have a template in 2012," Alvi said. The documentation will look to address interbank relationships, including concern over comingling of funds and minimising the use of commodity murabaha, he added.